FOMC Preview The case for a hawkish surprise

Last week and this week mark an unusual confluence of central bank meetings; Already this month, we’ve heard from the Bank of Canada (on hold), Reserve Bank of New Zealand (cut rates to 2.25%), European Central Bank (enacted a suite of easing measures), and Bank of Japan (on hold) and before the week’s out, traders will get the latest updates from the Federal Reserve, Bank of England, and Swiss National Bank (all of which are expected to leave policy unchanged, though the SNB meeting could be interesting as we noted yesterday).

According to the CME’s FedWatch tool, fed funds futures traders are pricing in exactly a 0% chance that the Fed will raise interest rates tomorrow, but even though the US central bank is expected to remain on hold, that doesn’t mean that we won’t see a market reaction to tomorrow’s Fed festivities. Tomorrow’s meeting marks one of the "bigger" quarterly meetings when the Fed updates its economic forecasts and Fed chairwoman Janet Yellen conducts a press conference in addition to the release of a traditional monetary policy statement.

Traders will first turn their attention to the Fed’s monetary policy statement, which is expected to be modestly more optimistic than January’s relatively cautious release. The biggest highlight in that statement was the addition of a sentence noting that the Fed was "closely monitoring" global economic and financial developments. Now that most financial markets have recovered from their lows, the central bank will likely show less concern with tightening financial conditions.

One potential wild card in the statement would be if the Fed characterizes the risks to the economy as "nearly balanced"; the central bank used this terminology before hiking interest rates in December, and some traders may take that as a signal that another increase is likely (akin to the ECB promising vigilance" before tightening policy under former president Jean-Claude Trichet).

Just as importantly, Fed members will update their economic forecasts in the Summary of Economic Projections (SEP). Given the recent strength in a number of inflation measures, the members’ projections for inflation (Core PCE) should remain relatively stable, while the forecasts for unemployment and economic growth will also be closely watched by traders. As always, the Fed’s "dot chart" of interest rate expectations may be the most important component of this release. As it currently stands, traders (according to CME FedWatch once again) are pricing in a about a 40% of two rate hikes by the end of the year, whereas the Fed has been consistently more hawkish; therefore, we expect the vast majority of the interest rate "dots" to imply at least 2 interest rate rises by the end of the year.

Finally, reporters will try to pin down Dr. Yellen on the timing of the next interest rate hike in her press conference after the meeting. The presser will likely follow the standard back-and-forth parrying and dodging of questions with no concrete conclusions, but markets will likely remain on edge until Janet Yellen exits the stage, so active traders will still want to tune in.

As for market expectations, the balance of risks may favor a potential hawkish surprise. The Fed has consistently expressed a desire to normalize policy at a more aggressive rate than many traders, and with the greenback edging lower in the wake of the recent BOJ and ECB announcements, the case for a hawkish outlook has only strengthen in the last few weeks. If the Fed comes off as relatively optimistic tomorrow, we could see EUR/USD dip back below the key 1.10 level and USD/JPY rally back toward the top of its range at 114.50, if not higher.

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